Property Development 101 – Part 10

Property development can be a great way to make money, if you know what you are doing. The property development process can be a long and complex one, from finding a site and selecting the builder to financing the deal and building and selling. Property development can lead to significant profits, but it can also lead to significant losses so the more you have planned and thought about your project, the more likely you are to succeed. Remember the old saying, “A failure to plan is just a plan to fail”.

This “Property Development 101” series won’t be able to teach you everything there is to know about property development. However, if you have read each instalment, you would have learnt about the fundamentals of property development and it should have made you aware of what questions you need to ask so that you can make educated and informed decisions.

In this “Property Development 101” series, I have outlined the major steps involved in property development. These include:

Setting your goals

Research

How to find development sites

Choosing the best site

Drawings

Feasibility studies

Working with council

Selecting a builder

Finance

Project management

Real estate agent/property manager

Tax

In the first instalment I outlined some strategies in relation to goal setting and research.

In the second instalment I detailed some methods on searching for development sites and then some considerations when selecting the best site to develop.

In the third instalment I provided an insight in to the design and drawings for a development.

In the fourth instalment I looked at one of the most critical components of property development, the feasibility study.

In the fifth instalment, I outlined what to do when working with your local council or shire so as to obtain approval for your development.

In the sixth instalment, I addressed a number of issues you need to consider when selecting a builder for your project.

In the seventh instalment I touched on some of the major considerations in relation to property development finance.

In the eighth instalment I discussed the benefits of project management.

In the ninth instalment, I outlined why and how local real estate agents and property managers can assist you.

In Part 10 (which is the final instalment), I will address some of the tax issues you need to be aware of when developing property. The tax issues mainly relate to the Australian situation but the general principles can apply to wherever you are undertaking your property development.

Overview

Tax is a key issue when developing property. A smart developer will try and minimise their tax in a number of ways. Consulting with the accountant and setting up the correct ownership structures before you buy the property is just two of the preliminary steps you need to undertake.

Some of the major considerations so far as tax are concerned (in particular in Australia) are:

Capital Gains Tax (CGT)

Income Tax

Goods and Services Tax (GST)

Margin Scheme

Capital Gains Tax or Income Tax

One of the first questions you need answered is “Will the profit/income made from the development be considered as a capital gain or income. This is very important for a number of reasons but the main benefit of paying CGT instead of income tax is if you build and then rent the property for at least 12 months, you may qualify for the CGT discount of 50%. In other words, you could halve your tax bill!

To help determine whether CGT or income tax will apply, it needs to be determined if you are “carrying on a business”. If the Australian Tax Office (ATO) deems that you are carrying on a business, any profits you make on the sale of the property will be classed as income. So, what does “carrying on a business’ actually mean?

Carrying on a Business

Whether you are carrying on a business is a question of fact and degree. The following tests are applied:

Scale of operations – the larger the development(s), the more likely it is to be a business.

Your intention to make a profit – this seems odd as I don’t know anyone who develops property without the intention of making a profit!

How often are you developing – the more regularly you develop, the more likely you are to be deemed to be carrying on a business.

The amount of capital you have invested – the more money you invest, the more likely you are to be deemed to be carrying on a business.

Whether you are keeping proper accounting records – this is similar to the intention to make a profit. Why wouldn’t you keep proper records!

Are you developing on a full-time or part-time basis – the more time you spend on developing, the more likely you are to be deemed to be carrying on a business.

Level of skills and knowledge – if your skill level and knowledge is high, you are likely to be considered as running a business.

Does a business plan exist – if one does exist, you’re more likely to be considered as running a business.

No matter how small a developer you are, you should meet the conditions in relation to making a profit and keeping records. How relevant the other criteria are to your development activities will determine if you are carrying on a business or not and whether you will need to pay income tax or CGT.

Basically, if you are undertaking a one-off project, you probably won’t be considered to be a carrying on a business. However, if you are doing this once every couple of years or more regularly, you will probably be considered as carrying on a business by the ATO. If this is the case, the entire profit will be liable to income tax rather than CGT and there is no chance that you have the opportunity to halve your tax bill through the CGT discount. However, if it is considered as income and you make a loss, this loss can be offset against other assessable income (but who wants to develop property and make a loss).

Goods and Services Tax (GST)

The GST is Australia’s version of the Value Added Tax (VAT). In general, residential property investors don’t need to worry about the GST. However, if you are a property developer, GST is a major consideration because unlike income tax or CGT which is only payable if you make a profit, GST will need to be paid whether you make a profit or loss!

One of the first questions you will need to ask your accountant is if you have to register for GST. In Australia, you will be required to register for GST if your annual turnover is over $75,000 and you are considered to be “carrying on an enterprise”. I don’t know too many developments that cost less than $75,000 so just based on this, you should register for GST. However, not all developers are considered to be carrying on an enterprise.

Did you notice the difference in terms? To determine whether your profit was classed as income or capital gain, it needed to be determined whether you were carrying on a business. For GST purposes, it needs to be determined if you are carrying on an enterprise. What the?!?

An enterprise is defined as an activity or activities done in the form of a business or in the form of an adventure or concern in the nature of trade. Confused? Let me explain with a couple of examples that the ATO provides on their website, www.ato.gov.au.

Astrid and Bruno live on a large suburban corner block. They decide to subdivide and cut off the backyard to allow Greta, their only child, to build a house in which to live. Astrid and Bruno pay for all the subdivision costs and Greta pays for the cost of the new house. This is viewed not to be an enterprise by the ATO.

Prakash and Indira have lived in the same house on a large block for many years. They decide to sell and move but want to maximise the sale proceeds. They decide to demolish their existing house, subdivide into two allotments, build a new house on each block and sell the new houses. This activity is an enterprise, according to the ATO.

Can you see a difference? For Astrid and Bruno it is more of a family venture whereas for Prakash and Indira it is purely a money making exercise.

Margin Scheme

The margin scheme is one method of calculating the GST payable on the property. The term ‘margin’ refers to the difference between the price you paid for the land and the sale price of the new dwellings. For example, if you paid $500,000 for the block of land, spent $500,000 on the development and sold it for $1.2 million, the margin is $700,000 ($1,200,000 – $500,000). If you were registered for GST, your GST liability would be 1/11 of $700,000 which is approximately $63,600. In addition to this, you could claim GST credits on the development costs which means you might only be out of pocket about $20,000.

If you weren’t registered GST, you would have to pay 1/11 of $1,200,000 which is approximately $109,000. Can you see the difference? Register for GST and pay $20,000 or don’t register and pay $109,000. I know which one I prefer!

This last article in the series has been one of my longest as tax is a very involved subject. I haven’t examined all the tax issues in detail as taxation issues are treated differently, depending on which country you are developing in.

If there are only two things you remember from this article, it should be this: